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Experimental Economics - Study of Economic Behaviours

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Last updated date: 20th May 2024
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What is an Experiment Method?

In the mid-1950s, Vernon Smith, for the experimental market, developed the basic structure of experimental economics. 


The meaning of Experimental Research is a technique of economics in which scientific experiments are used to study economic theories and human behaviours. Human subjects are used in economic experiments to respond to incentives in a controlled laboratory setting that simulates the key economic aspects of a theoretical or naturally occurring economic problem.


Vernon L Smith


Vernon L Smith


Objectives of Experiments

To categorise the types of experiments, various parameters can be considered. However, one of the most important ones is the models they are trying to evaluate. The experiments are broadly categorised based on the following objectives:

1. Testing the Strong Assumption of Theories 

The assumptions that are used in economics can be quite strong sometimes. The sensitivity of their predictions can be tested by the experiments by weakening those assumptions. 


2. Institutional Designs Comparison 

Alternative institutions or policies can be put into practice in a lab setting, and the results can then be compared based on the effectiveness or other criteria because there is no guidance provided by theory while choosing the Institutions or policies.


3. The Evaluation of Theoretical Predictions

Based on the results of lab experiments, economic theories are tested. For example, market prices are predicted by general equilibrium theory at the point where supply and demand intersect. Experiments with a wide range of trading organisations have demonstrated that this forecast is accurate.


4. Evaluating Assumptions

Experiments do not just examine the predictions of a theory but also the assumptions of theories. Behavioural economists often use this method when trying to replace standard rationality assumptions with more accurate descriptive models that are nevertheless tractable mathematically.


5. Recognising Stylised Facts

In lab experiments, replication is quite prominent, which is why experiments are frequently used to find patterns in behaviour that may or may not be consistent with theory.


Types of Methods Used to Forecast Demand in Economics

In economics, demand forecasting is anticipated by using experiments. However, there is no specific technique that can be used for forecasting.  The techniques are used to protect against uncertainties and risks in the future. 


The first method involves predicting demand by gathering data from experts or through surveys about consumers' buying habits. The second approach involves forecasting demand using statistical methods with the help of prior data.


The techniques are divided into two categories based on long-term and short-term forecasting. The survey method is used for short-term forecasting, while statistical methods are used to study the long-term forecasting


Following are a few methodologies used in experimental economics: 

Survey Method

Surveys are conducted in this method, In which the future demand of consumers is predicted based on the current demand for goods and services. Survey methods are of three types: 

1. Market Experiment Method

Market experiment methods are conducted in an actual market scenario. Future demand is predicted by conducting experiments with the use of varying expenditures and prices and recording the data. However, there are a few limitations to the market experiment method.

  • The outcome of an experiment might be affected by certain reasons, such as natural calamities and political or National unrest.

  • Another limitation is that this method of market experiment is quite expensive to conduct.


2. Opinion Poll of Experts

One of the effective methods used is the opinion of experts, which in most cases happens to be the sales manager of an organisation. Since they are aware of consumer behaviour, they are able to predict future behaviour and the demand for products.


3. Delphi Method 

Using this technique, a number of experts are individually questioned about the demand for products in the future. To obtain consensus, the questions are repeatedly asked. Additionally, in this strategy, each expert is informed of the estimates made by the other experts in the group so that they can revise their estimates in consideration of the estimates of others.


Statistical Method

With this approach, demand is predicted using cross-sectional and historical data. For long-term forecasting, this method is used.


Market surveys and interviews with people are used to gather cross-sectional data. While historical data is information from the past that has been gathered from a variety of sources, such as market survey reports and balance sheets from previous years. The following are the types of statistical methods used:


1. Barometric Method

In the barometer method, demand forecasts are based on past occurrences or significant current variables. For example, there is a national festival approaching in society, and it is predicted that the demand for sweets will rise significantly in the market. In this way, the current trends of a market are studied.


2. Trend Projection Method

This method is also known as the least square method. This approach uses past data from the books of accounts from the prior year to analyse sales forecasts. Additionally, this approach makes the assumption that the variables like sales and demand that influenced previous trends would remain the same in future as well. 


3. Econometric Method

This method is considered the most reliable method than other methods for forecasting economic trends. Statistical tools are combined with Economic theories to predict future trends in this economic experiment method. There are two types of econometric methods:

  • Simultaneous Equations - There are several independent equations in this set of equations. Due to the fact that they contain a finite number of equations, simultaneous equations are sometimes referred to as systems of equations. There are two variables used in this method. 

A variable in a statistical model that is affected by or determined by its relationships with other variables in the model is known as an endogenous variable. In contrast, the variable whose value is determined outside the model is called an exogenous variable

  • Regression Method - This method is used to predict the demand function Of a product. Here, the demand is considered the dependent variable, while the variables that predict demand are called independent variables.


Advantages and Disadvantages of the Experimental Method

Experimental methods have a few advantages and disadvantages as well. The advantages are:

  • Researchers can examine different cause-and-effect relationships that a product, theory, or idea can produce by manipulating factors.

  • Experimental research can consistently produce results that are precise and relevant since it provides such a high level of control.

  • Experimental methods help in determining the outcomes that might be achievable for a given product, theory, or idea. Each variable can be controlled alone or in different combinations.


Apart from the above-mentioned advantages, the experimental method has a few disadvantages, such as:

  • The environment of trial participants may have an impact on them. As a result, they can respond based on what they believe the researcher wants to hear rather than how they actually feel.

  • Performing experimental research also involves removing certain unnecessary factors. As a result, a rather artificial setting is created.

  • Experimental methods tend to have human errors, and researchers involved in them can make certain errors while conducting the experiment, which will eventually affect the results of the experiment.


Summary

The term "experiment method" refers to a method in economics that uses scientific experiments to study economic theories and behavioural patterns. The two important methodologies used in experimental economics are survey methods and statistical methods. The advantages of experimental methods are the study of cause and effect relationships, relevant results and control over variables. The disadvantages of experimental methods are human error, the impact of environmental factors on participants and the creation of an artificial setting.

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FAQs on Experimental Economics - Study of Economic Behaviours

1. What are the two ways in which the market experiment method is conducted?

These are the ways in which the market experiment is conducted:

  • An experiment in the Actual Market - This type of demand forecasting predicts demand based on data collected from the actual market. The forecaster may choose a specific region of the market and carry out the estimation of demand there.

  • An experiment in Simulated Market - In contrast to actual market experiments, which are conducted in real marketplaces, this experiment involves the selection of a target customer group and the conducting of a market experiment through a simulated market.

2. Explain Vernon Smith’s early experiments in economics.

Vernon Smith initially studied the differences between theoretical and actual equilibrium prices. He discovered that conventional economics can still forecast the behaviour of groups of people accurately even though humans have cognitive biases. In contrast to mathematical models on a chalkboard, Vernon Smith created a system that could examine behaviour in a controlled laboratory environment or out in "the field." Before incorporating economic ideas into policy, it is essential to test them on actual humans. Economists can modify existing ideas in light of fresh data or develop new ones by taking a closer look at why economic theories hold up in the present based on the decisions individuals make.

3. What role does experimental economics play in the development of theories?

To understand better the reasons and elements that affect how a market functions, experimental economics is used. Pioneer Vernon Smith created a methodology that enabled academics to measure the impact of policy changes before they were put into effect. The fundamental focus of experimental economics is conducting tests in a laboratory setting with adequate controls to minimise the impact of outside factors. To assist policymakers in making better choices, researchers evaluate the effects of policy changes prior to their implementation.